“Иқтисодиѐт ва инновацион технологиялар” илмий электрон журнали. № 7, сентябрь, 2013 йил
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U.Burkhanov.,
Kh.Khudaykulov
INVESTMENT VALUATION IN EMERGING MARKETS: OPPORTUNTIES
& SPECIFIC FACTORS
Несмотря
увеличению
инвестиционного
потока
быстро
в
развивающихся странам, присуствие многих негативных факторов как
отсутсвие
празрачности,
низкий
уровень
ликвидности,
коррупция,
волатилность рынков, плохое управление, налоговая нестабельность и высокые
транзакционные расходы затрудняют формирование универсальных методов
оценки активов. В исследовании анализированы 5 моделей и в результате
показана возможность использование в Узбекистане модела CAPM с
коррекциями на политические риски, а также кредитная модель страны.
Тез суръатларда ривожланаѐтган мамлакатларда инвестиция оқими
кенгаяѐтган бўлишига қарамасдан, шаффофлик, ликвидлилик, коррупция,
волатиллик, бошқарув, солиқлар ва транзакция харажатлари каби омиллар
активларни
баҳолашнинг
“энг
яхши”
усулларини
шакллантиришни
қийинлаштирмоқда. Тадқиқотда активларни баҳолашнинг беш модели таҳлил
этилган. Ўзбекистон шароитида активларни баҳолашда мамлакатнинг
кредит модели ҳамда сегментация ва сиѐсий тузатиш киритилган
CAPM
дан
фойдаланиш мумкинлиги тадқиқотлар натижасида кўрсатиб берилган.
Key words: emerging markets, valuation, discount, risk, cash flow.
Introduction
The global economy faces a dilemma. Attempts to boost growth have lowered
rates in advanced economies. The resulting hot money has moved exchange rates out
of line with fundamentals, creating inflation and asset appreciation in the developing
world
1
[1]. Also, emerging markets will continue to draw the attention of the world‘s
investors in the context of continuing rescission in some parts of Europe. The roughly
30 emerging countries widely followed by investors grow at real rates two or three
times higher than developed countries
2
. As emerging markets continue to grow
economically and leave their footprint on the global economy, valuing companies
from such nations will be an important part of building a truly global portfolio. To
many, valuing firms from an emerging market seems much too difficult to undertake.
Investment valuation: the case of Uzbekistan
While the idea of placing a value on an emerging market firm may seem
difficult, it really is not much different than valuing a company from developed
economy. Valuation in emerging markets is important for the following reasons [2]:
First
, despite the fact that in developed markets, best practitioners and scholars
seem to converge on mainstream valuation practices (Bruner et al., 1998, Graham and
1
The world‘s corporations with $3.8 trillion in cash holdings at the end of 2009, have access to cheap capital, with the
long-term interest rates languishing near 1.5 percent.
2
Indeed, as developing economies continue to pick up the pace of urbanization, the prognosis for companies that can
tap into the growth over the next decade looks promising.
“Иқтисодиѐт ва инновацион технологиялар” илмий электрон журнали. № 7, сентябрь, 2013 йил
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Harvey, 2001) there is currently no clear single ‗best practice‘ for the valuation of
assets and securities in emerging markets. However, in emerging markets, practice
differs more widely (Bohm et al. 2000). There are substantial disagreement about
fundamental issues, such as estimating the cost of capital for discounting cash flows
in emerging markets.
Second
, emerging markets differ from developed markets in
areas such as accounting transparency, liquidity, corruption, volatility, governance,
taxes, and transaction costs. Surely, these differences affect firm valuation.
Third
,
investment flows into emerging markets are material. Also humanitarian
consideration not to be ignored is: better valuation practices may enhance the flow of
investment capital, the allocation of resources, and thereby increase social welfare in
emerging markets.
The Economist‘s analytical division - Economist Intelligence Unit - a respected
British magazine has published a list of countries economies with the fastest
economic growth in the world. According to this report GDP growth rate of top ten
countries are the following: Qatar 15.8%, Ghana 12%, Mongolia 12%, Eritrea 9.3%,
Ethiopia 9%, China 8.9%, India 8.6%. In 2011 Uzbekistan was in the top ten with the
annual growth rate of 8.3% [3].
How valuation can be practiced in uzbek economy in the absence of proved
models? Economic growth in Uzbekistan has accelerated from around 4% to over 9%
while the inflation rate has stabilized [4]. The country possesses unique local
advantages which could support the long-term growth of the economy and increase
the welfare of the population. Among the local factors are a relatively low cost and
educated labor force, considerable natural resources and a central location in the
Central Asian market.
Figure 1: GDP growth (annual %) in Uzbekistan
Source: http://www.afs-research.com/eng/article/5294/
More than 40 laws on privatization, entrepreneurship and investment
promotion have been passed. Recent regulatory reforms, liberalization and the
privatization of large state enterprises have had a positive effect on economic growth
and investment, particularly foreign direct investment. Other economic factors that
make Uzbekistan attractive to foreign investors include:
undervalued assets,
investment incentives, adequate infrastructure, low cost of energy/utilities, large
internal market of about 30 million people, and free trade zone with 11 CIS member-
“Иқтисодиѐт ва инновацион технологиялар” илмий электрон журнали. № 7, сентябрь, 2013 йил
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states forming a regional market of over 277 million people.
There are many project
opportunities in the current investment program in oil and gas, coal, mining, electric
power generation, chemical, food processing, and tourism.
2007 has been marked by a great number of deals with the participation of
foreign investors
in Uzbekistan. Most of investments were in the telecommunication,
mining, chemical and transportation sectors. The volume of foreign direct
investments in 2007 grew to USD 1,013.6 million from USD 683.8 million in 2006.
Table 1: The largest transactions with participation of foreign investors in
Uzbekistan realized in 2006-2008.
Year
Object of Investment,
Industry
Investors
Purchased
%of shares
Amount of
investment
MlnUSD
2006
Investment commitment
within 4 yeards in oil and gas
(2006-2010)
―Gasprom‖ (Russia)
-
400
2006
―Unitel LLC― and ―Buztel
LLC‖, Telecom‘s
―Vimpelkom‖
(Russia)
100%
200 and 60
correspondingly
2006
JSC ―Ahangaran Cement‖,
Constr/n materials
―Eurocement Group‖
75.5%
Transaction
is not disclosed
2006
JSC ―Khorazm Shakar‖
(―Khorezm Sugar‖), Food
‖SEID
Нandelsgesellschaft
m.b.H― Austria)
99.43%
17.6
2006
Construction of brewery
plant in Tashkent, Food
―Baltic beverages
Holding AB (BBH)‖
(Sweden)
-
€38 Mln
2007
Uzdunrobita, Telecom‘s
―Mobile Tele
Systems‖ (Russia)
100%
250
2007
COSCOM, Telecom‘s
―TeliaSonera‖
(Sweden-Finland)
73.97%
151
2007
Oxus Gold Plc, Mining
―ZeroMax LLC‖
(Switzerland)
30%
83.6
2007
OJSC ―Electrohimprom‖,
Chemical
―MAXAM Corp.
S.A.U.‖ (Spain)
49%
22.4, investment
obligations - 53
2007
East Telecom, Telecom‘s
―KT Corp.‖ (S.Korea)
51%
Transaction
is not disclosed
2007
Ammofos, Chemical
―MAXAM Corp.
S.A.U.‖ (Spain)
49%
18, investment
obligations - 30
2008
SNG Holdings, Oil and gas
―LukOil‖ (Russia)
100%
580
2008
Yo‘lreftrans, Transportation
―Shindong Enercom
Inc‖ (Korea)
47%
17.5
2008
Spinning and weaving
factory #2 of Bukharatex,
Textile
―SIS Sayilgan Iplik
Tekstil A.S.‖ (Turkey)
100%
12.42
Source:
UNDP.
Investment opportunities
in Uzbekistan. Catalogue. 2009.
Valuation models can be used
The use of different valuation methods is the crucial element of any investment
decision making. Five types of widely known models — the CAPM, international
“Иқтисодиѐт ва инновацион технологиялар” илмий электрон журнали. № 7, сентябрь, 2013 йил
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САРМ, CAPM adjusted for political risk and segmentation, multifactor models, and
the country credit model — that the investor can use when estimating a return rate in
emerging markets. The choice depends on the investor's perception of the quality of
the information environment and the segmentation between the emerging market and
the investor's local market. For emerging markets that are integrated with global
markets and for which quality information can be obtained useful asset-pricing
approaches include the CAPM, the international CAPM (ICAPM) and, multifactor
model. On the other hand, the CAPM adjusted for political risk and segmentation is a
useful approach when the investor considers that the market analyzed is not
integrated with the home market. Finally, when quality information cannot be
obtained the credit model can be used.
The point of departure is the familiar
CAPM
, which embodies the risk-return
relationship fundamental to finance. The simplest starting point for asset pricing uses
the home country risk-free rate and market premium with a beta appropriate for the
target – for example, a beta selected from an average of company betas in the home
country. Thus,
Where
R
f
is the risk-free rate prevailing in the home country, ß
i
═ σ
imarket
/σ
2
market
is the beta
appropriate for the target,
and R
market
- R
f is the home equity market risk premium.
Several authors have argued that, as the world becomes more integrated and more
investors hold globally diversified portfolios, the relevant measure of a stock‘s risk is
it‘s covariance with the world market. Thus, the traditional CAPM model should be
modified with substitute parameters that reflect risk and return in world markets/
accordingly, the formula for the
ICAPM
is:
Where
R
f
is the world risk-free rate,
ß
i
w
is the world beta of asset i, and
R
m
w
-R
f
equity risk premium (in dollars).
The ICAPM assumes that markets are integrated and the reliable information can be
obtained for feeding the model.
Lessard (1996) described the country risk premium method. This method adjusts
the
CAPM to account for segmentation and political risk
:
where
π
is country credit spread, measured by yield differentials between U.S. government bonds and U.S. dollar
denominated sovereign bonds of the same tenor; β
i
us
is the domestic beta of asset
i
in the US; and ß
country
is the beta of
the target country market vs. U.S. market.
Because the country credit
spread is calculated directly from yields on dollar-
denominated bonds rather than from local currency bonds, it does not incorporate any
currency R
f
US
+
π
,
then measures the sovereign risk-free rate denominated in US
dollars [5].
Various researchers argued that the risks in international investing are not adequately
modeled by the ICAPM model and thus have suggested using more fully specified
econometric models. Under this approach, the required return on a security is equal to
a risk-free rate plus the exposure of the stock to various factors, which could be
“Иқтисодиѐт ва инновацион технологиялар” илмий электрон журнали. № 7, сентябрь, 2013 йил
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macroeconomic factors (such as economic growth, inflation, and consumer
confidence) or company factors (such as size, leverage, and earnings volatility):
The main advantage of
multifactor models
is the explicit inclusions of different
factors that can be affect the required rate of return requested by investors. As a
result, multifactor models display higher power than other models. Furthermore,
because one of these factors can be market integration, the multifactor model can be
used regardless of the assumption about the degree of global integration of a
particular market. On the other hand, multifactor models require a great amount of
data and computational analysis. They also require including the right factors but not
to suggest which ones they should be. Finally, the information that feeds the models
must be reliable (or at least systematically unreliable) in order for investors to have
confidence in the output.
Whereas the previous methods assume that reliable data can be found, the
credit
model
relaxes this assumption and tries to substitute for lack of information (although
it can also be used with reliable information). For instance, given market
imperfections, beta may have little meaning in an emerging market setting, and some
local market settings simply may
not have a stock market. Erb, Harvey, and Viskanta
(1996) offered a model based on the country credit risk rating:
where IICCR is the country's Institutional Investor Country Credit Rating.
By relying on non-equity market measures, the model can circumvent estimation
difficulties related to the lack of market information. Also, measures of country risk
impound assessments of political, currency, segmentation, and other types of risks to
which an enterprise might be subject. Furthermore, estimates of cost of capital may
be obtained from sources and do not require a large volume data analysis. Because
this model estimates an average required equity return for a country, however,
adjusting the estimate for company-specific risk is necessary[6]. The lack of data for
investment analysts and relatively weak financial markets make the country credit
model more valid in the case of Uzbekistan.
Table 2: Applicability of valuation models
Information environment
Target country
integrated
Target country
segmented
Foreign capital market information is easily
obtained and believed to be reliable (e.g. the
foreign capital market is relatively competitive
and
efficient
and
financial
performance
reporting is relatively transparent and reliable).
CAPM
Multifactor
model
Multifactor model
Credit model
CAPM adjusted for
political risk and
segmentation
Foreign capital market information is not easily
obtained and/or is unreliable (e.g. the foreign
capital market is relatively less competitive and
CAPM
CAPM adjusted for
political risk and
segmentation
“Иқтисодиѐт ва инновацион технологиялар” илмий электрон журнали. № 7, сентябрь, 2013 йил
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inefficient,
and/or
financial
performance
reporting is relatively opaque and unreliable).
Credit model
Obtaining the DCF inputs
A major difficulty in deriving free cash flow estimates in emerging markets is
estimating the
cost of capital
for a firm. Both a firm's cost of equity and cost of debt,
along with the actual capital structure itself have inputs that are a challenge to
estimate in emerging markets. The biggest difficulty in estimating the cost of equity
will inherently be deciding on the risk-free rate, since emerging market government
bonds cannot be considered riskless investments. Therefore, adding the inflation rate
differential between the local economy and a developed nation and using that as a
spread on top of that same developed nation's long-term bond yield is the method
used by the most of practitioners.
In the case of estimating the cost of debt, using comparable spreads from
developed nations on similar debt issues to that of the firm in question, and adding
that on to the derived risk-free from above will give an acceptable pre-tax cost of
debt. Finally, to choose an appropriate capital structure, it is best to use an industry
average. If no local industry average is available, using a regional (global) average
will work as well. Another key to arriving at a usable value via the DCF method is
including a country risk premium to the firm's weighted average cost of capital
(WACC). The reason for this is to be sure we are using an appropriate discount rate
when using nominal figures in discounting the firm's future cash flows. There is hard
and fast rule to choosing a country risk premium, quite often the premium is
overestimated. A good method suggested by the CFA Institute is making sure that the
historical returns of a company's stock is taken into account
3
[7].
The last piece of the valuation puzzle, much like with forms from developed
economies, is to compare the firm to its industry peers on a multiple basis. Evaluating
the company against similar emerging market firms on multiples, namely the
enterprise multiple, will help give a clearer picture of how the firm stacks up relative
to others within its industry, especially if said peers compete within the same
emerging economy. The given structure of Tashkent stock exchange is example of
how developing country‘s stock exchange is risky, where practicality of using CAPM
based approach is almost equal to zero.
3
A further issue needs consideration here – what is the ―risk-free‖ rate which should be used as a base for any of these
calculations? There are several methods: the current market rate for government bonds (Ireland, the Netherlands and the
US); or a fixed rate based on the historical average for government bonds; or the ―social time preference rate‖, the rate
which private investors expect to receive for foregoing present consumption in favor of future consumption assuming is
a risk-free transaction. (E.Yescombe, 2007).
“Иқтисодиѐт ва инновацион технологиялар” илмий электрон журнали. № 7, сентябрь, 2013 йил
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Figure 2: The structure of UZSE by sectors
Source: http://uzse.uz/new/analyt/files/stat/1.doc, P.8
FACTORS SPECIFIC TO EMERGING MARKETS
The effect of
exchange rates, interest rates and inflation
are few factors
specific to emerging markets that must be dealt with
.
Exchange rates are regarded as
relatively unimportant by most analysts, since although the local currencies of
emerging market countries can vary wildly in relation to the nation's purchasing
power parity (PPP). Nonetheless, a sensitivity analysis can be performed to determine
the foreign exchange impacts due to local currency fluctuations. However, inflation
plays a larger role on valuation, especially for firms operating in a potentially high
inflation setting. In order to neutralize the effects of inflation on the DCF estimate, it
is necessary to estimate future cash flows in both nominal (ignoring inflation) and
real (adjusting for inflation) terms. Making the appropriate adjustments to the
numerator and denominator of the DCF equations removes the impact of inflations.
To estimate a discount rate appropriate for foreign cash flows, differences in inflation
must be accounted for. One can use the concept of PPP to solve for foreign capital
costs from home capital costs. Assuming constant real rates of return among
countries, the ratio of the capital costs between two counties is equal to the ratio of
the inflation rates between them. Rearranging these ratios yields this useful formula:
where
is a foreign cost of capital,
home coat of capital,
foreign inflation rate
home inflation rate.
The classic CAPM would be appropriate for valuation across borders of two
highly integrated country economies, such as the United States and Canada. For
instance, a U.S. investor could use U.S. based betas with the U.S. risk-free rate and
equity premium to discount flows of Canadian dollars translated into U.S. dollars.
There can be used different approaches to estimate cash flows. Two of them given as
example that foreign investor can use in Uzbekistan.
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Figure 3: The approaches from deriving a US Dollar NPV from Uzbek soums
(UZS) free cash flows
Table 3: The difference of A and B approach
Characteristic
Approach A
Approach B
Key features/key
bets
PPP holds
Inflation forecasts in UZS
and dollars are appropriate.
Country risk premium
estimate is
appropriate.
Local capital market has
good availability
and quality of data.
Local capital costs are free-market yields
Strengths
Theoretical rigor
Simplicity
Can use (more reliable)
capital market information
from developed countries
Translation at current spot rates
Weaknesses
PPP does not hold in all
markets at all times
Availability and quality of local capital
market data
Long-term forecasting of
inflation is extremely difficult
Implicitly assumes US
interest rates are consistent
with forward UZS/dollar
exchange rates.
Betas simply not available for many stocks
in emerging markets. Investors must
estimate their own betas.
Many interest rates are heavily administered
by central banks and do not reasonably
reflect inflation expectations or required real
rates of return.
Translate those local cash flows to home currency at forward exchange rates as
estimated from the IRP formula:
Approach A
Translated at forward
Soum/Dollar exchange rate
UZS-Denominated
Cash flows
US Dollar-Denominated cash
flows
UZS-Denominated
NPV
US Dollar-Denominated NPV
Approach B
Discounted at UZS
WACC
Approach A
Discounted at
US Dollar
WACC
Approach B
Translated at current spot
UZS/Dollar exchange
rate
“Иқтисодиѐт ва инновацион технологиялар” илмий электрон журнали. № 7, сентябрь, 2013 йил
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To use this formula, the investor needs a view about the long-term inflation
rates in the foreign and home currencies. Discount local cash flows at a rate
consistent with a local currency-based estimate of foreign country inflation, country
political risk, country beta, and industry beta.
SUMMARY
To sup up, as emerging markets continue to grow economically, valuing
companies from such nations will be an important for building a global portfolio.
Despite the fact that in developed markets, best practitioners and scholars seem to
converge on mainstream valuation practices there is currently no clear single ‗best
practice‘ for the valuation of assets and securities in emerging markets.
The five types of models: the CAPM, international САРМ, CAPM adjusted for
political risk and segmentation, multifactor models, and the country credit model —
that the investor can use when estimating a return rate in emerging markets.
A major difficulty in deriving free cash flow estimates in emerging markets is
estimating the cost of capital for a firm. The effect of exchange rates, interest rates
and inflation are few factors specific to emerging markets that must be dealt with
.
Among other factors, inflation plays a larger role on valuation.
REFERENCES
1.
[1] M.Spence, R.Dobbs. The era of cheap capital draws to a close.
Mckinsey Global Institute. February 2011.
2.
[2] R.Dobbs, S.Lund, and A.Schreiner. How the growth of emerging
markets will strain global finance. Mckinsey Global Institute. December 2010.
3.
[3] http://www.afs-research.com/eng/article/5294/
4.
[4] International Monetary Fund - 2011 World Economic Outlook.
TheGlobalEconomy.com
5.
[5] Donald R. Lessard. Incorporating country risk in the valuation of
offshore projects.
Journal of Applied Corporate Finance. Volume 9, Issue 3, pages
52–63, Fall 1996.
6.
[6] Wei Li, H.Richard. Valuation in Emerging markets. UVA-F-1455.
7.
[7] E.R.Yescombe. Public-private partnerships. Principles of policy and
Finance. Published by Elsevier ltd. UK. 2007.
